Friday, September 25, 2009

How strong the economic recovery will be depends on whether we believe that output will quickly return back to the trend that was following before the crisis. Economists tend to think in terms of potential output as driving the trend of output and recessions as being temporary deviations from this trend. During the recession the output gap becomes negative (output is below potential) and the recovery brings output back to its trend, closing the output gap.

There is, however, evidence that output does not always return to its trend after a deep crisis. The IMF World Economic Outlook has just released its two analytical chapters from the September/October issue. Chapter 4 (which can be found here) deals with this issue: whether output will return to trend after the crisis. Their conclusion, after looking at many different historical cases, is that banking/financial crisis tend to leave a permanent (or at least a medium-term) scar on the economy. Here is a picture from Korea after the 1997 crisis (picture borrowed from Chapter 4 of the World Economic Outlook).

As we can see, 7 years after the crisis, output is still far from the pre-crisis trend. There are many other examples like this one and the evidence supports the notion that there is a mid-term costs of financial crisis so that output stays below trend for several years.

There are, however, some examples where the output loss is smaller. Some of the conditions under which the mid-term output cost could be low are:

- having a low initial decline on output (e.g. the severity of the recession during the first quarters).

- having a level of investment before the crisis which is not far from historical standards (e.g. the pre-crisis boom did not drive investment rates too far from historical levels)

- having more policy room to maneuver (low inflation, current account balance) before the crisis

The conclusions of the article state that:

"For the most part, the implications of our analysis are sobering for the medium-term output prospects in economies with recent bank- ing crises. The historical evidence suggests that output in many of these economies may remain well below precrisis trends in the medium run."

And policy makers are warned once again about the difficult balance in their exit strategies.

"Looking ahead, the timing for the withdrawal of the extraordinary amount of monetary and fiscal stimulus that has been implemented in many countries will be impor- tant. On the one hand, a premature exit could stifle the recovery. On the other hand, delaying the withdrawal of stimulus could be inflationary."

Tuesday, September 22, 2009

While most advanced economies have displayed significant drops in GDP during the last years, the behavior of labor market variables (employment, unemployment, number of hours) has been quite different across countries.

In countries such as the US or Spain we have seen a large decline in employment/hours and the corresponding increase in unemployment. In countries such as Germany or France or Sweden, employment and hours have fallen much less.

Below is data on labor productivity measured as GDP per hour worked in four countries (data is annual so we are missing the first quarters of 2009). In the case of Sweden and Germany we can see that the fall in GDP has been much larger than the decrease in hours worked leading to a decline in productivity. In the case of the US productivity has remained stable. In the case of Spain the fall in employment and hours has been much larger than the decrease in GDP which has produced a doubling of the productivity growth rates in 2007/08 relative to the 2003-06 period.

Behind these figures we probably have a composition effect (different sectors being affected differently by the crisis) but also different labor market responses to the crisis, where in some cases there has been a conscious effort to reduce the impact on employment.

Antonio Fatás

Update (Sept 23): some have emailed me asking for an explanation of the differences among these countries. I do not have a great answer, my last paragraph was an attempt to put forward some hypothesis. It could be that the sectors that are being affected in a country like Sweden are the most productive ones, while in a country like Spain they are the least productive ones (e.g. construction). I have no evidence that this is the case but it is a plausible mechanical explanation. The second explanation that I proposed is probably more realistic: in some countries (Germany, Sweden) there has been a conscious effort with the help of trade unions to reduce the impact of the crisis on employment (e.g. accept a pay cut if the level of employment is maintained). We have not seen this in the US. In the case of Spain, the dual structure of the labor market has led to a large termination of temporary contracts and a significant reduction in employment.

Monday, September 21, 2009

It is very common these days to hear that the global economy has no way of recovering because the most powerful engine of global demand – the American consumer – is choking in debt. US household debt has reached $14 trillion in 2009, or 100% relative to GDP. At a recent conference in China, panelists were wondering how growth in the global economy would resume given that the American consumer had disappeared under the burden of debt.

On September 17, the Federal Reserve released their “Flow of Funds” report, where we can find data on household debt for 2009Q2. Indeed, this debt stands at $14.068 trillion or slightly less than 100% of GDP. Does this mean that the economy is doomed? There are two points that one has to take into account when evaluating the role of household debt in the economy.

1. Debt is only one side of the story. Households also own assets. Consumption is a function of (net) wealth, not only of indebtedness. Up to a first approximation what matters is the difference between assets and liabilities. Indeed, no one thinks that a person with $10 million in debt is going to cut his or her consumption, if you know that this person has $10 billion in assets. So, how do American consumers fare in terms of net worth? Below is a graph with three ratios – assets-to-GDP, debt-to-GDP and net-worth-to-GDP. Although household debt stands at 100% of GDP, assets owned by US households currently stand at $67.2 trillion or 475% of GDP. The net worth of the American households is estimated to be over 375% of GDP.

Are these assets sufficient? This is hard to tell because theory does not provide convincing guidance as to what the wealth-to-GDP ratio should be. But we can look at the data to see how these numbers compare to historical averages. The average ratio of US household net worth from 1952Q1 to 2009Q2 is about 350% (if we exclude the two bubbles, the ratio is 330%). In short, US households today have more net wealth than they had in normal times in the post WWII period. Contrary to all complaints, US households today are richer than at any point in time in the pre-1995 period (and again, this is relative to GDP; in absolute terms no one will be surprised that this statement is true).

But maybe it is the composition of debt that matters – people today live off their credit cards. It turns out that consumer credit has increased indeed over the past 20 years but the numbers are not shocking. From about 14% in 1990, consumer credit rose to 17.3% in 2009 (again the numbers are relative to GDP).

One counter-argument to the points that I raise above would be that all of this wealth is only on paper – we saw how bubbles deflate and therefore we cannot count $67.2 trillion is assets at their face value. To accept this argument, however, we must admit that the real estate bubble has not deflated yet. It could be true, but looking at data we find that house prices relative to income are close to their historical averages from the pre-bubble 1980s and 1990s. In other words, an argument that the wealth is only paper wealth should argue that the US is in a permanent state of a bubble.

2. Even if we concede that debt can reduce consumption for an individual, it is a bit trickier to make the same argument for the national economy. The reason is that the liability of one individual is an asset for someone else. In the graph above, the thin blue line is in fact included in the thick red line!

At first, it might be startling to think that indebtedness of one household is an asset of another one. But if you imagine a bank and its balance sheet, you can quickly realize that all the loans that banks give (assets for the bank) must be financed with a deposit, equity or another instrument on the liability side.

There are ways in which this “neutrality of debt” may break down. For example, if those who are indebted have a higher propensity to consume than the lenders, then debt will lead them to cut their consumption by more than the lenders will increase theirs (due to the wealth effect). This is possible and even plausible, but it is not clear whether empirically this effect is significant. Second, it might be that household debt is held by foreigners. Again, the data are not very supportive of this hypothesis because the net foreign asset position of the US is not (yet) devastating – less than 20% of GDP.

In general, many other “imperfections” in the market economy can result in the importance of debt for aggregate consumption, and I do agree that some of these imperfections are realistic and important. The main point of the argument is that we need a more nuanced view of why debt matters. We should keep in mind that the net worth of US households is still quite high (375% of GDP) and that debt should be viewed from a general equilibrium point of view and not only in absolute terms.

Here is a nice chart from John Fernald at the San Francisco Fed that shows the path of GDP after the last three recessions, including the current one. Using the NBER dates to set the beginning of the recession you can see that the first quarters of the current one were similar to those of the previous two but that a year into the recession the economy accelerated its decline. This made the current recession much longer and deeper than the previous two.

Looking at the forecast for the next 6 quarters, the pace of recovery is not that different from what we have seen before but we start at a much lower level and this makes GPD to remain below the path of the 1990 and 2001 recessions for the quarters (and years) ahead.

Friday, September 11, 2009

By now we all know that the global imbalances were created by excessive consumption in the US and high savings in China (and other countries). Indeed, if we recall that the current account balance is the difference between saving and investment, we will find that for the US over the past 20 years the increase in the current account deficit is almost entirely due to the increase in private consumption.

But what is exactly behind this increase? Do Americans spend more on cars, or toys from China, or is it something else? Here are the data:

As the graph below shows, consumption-to-GDP ratio stood at 62.71% in 1980Q1. The dramatic rise in consumption in the 1990s and early 2000s is clearly seen on the graph (the blue line). By 2009Q1 consumption-to-GDP ratio rose to 70.73%! When we look a little bit deeper, we realize that almost the entire increase is due to two factors: healthcare and education. Medical care plays the major role as its share in personal consumption expenditures rose from 10.2% to 18.3%. Education accounts for one percentage point in the increase in consumption.

Dealing with the rising costs of healthcare may indeed help not only resolve issues of healthcare provision in the US, but indirectly might be the most important tool for addressing global imbalances.

My reading of these articles is that there is a good deal of consensus around the following points:

1. Many (economists and non-economists) had expressed concerns prior to the crisis about economic imbalances such as excessive asset price appreciation or current account imbalances. They pointed out to the need of an adjustment, which could come in the form of a recession. As it has always been the case with recessions, forecasting the exact timing is not easy - it depends on how long imbalances are kept alive by markets, investors, policies (and luck).

2. There were several scenarios that were discussed prior to the crisis that could lead to a significant economic downturn. They involved a crash of the real estate market (which took place) and in some cases a reversal of capital flows as foreigners would stop lending to the US (or they would do so at much higher rates). This second scenario never materialized - the crash in real estate prices was enough.

3. Even among those who were concerned with the possibility of a crisis, very few understood the potential magnitude of the crisis, mainly because they could not foresee the collapse of the financial system that we witnessed a year ago. Here is a quote from Frederic Mishkin (who was a member of the Board of Governors, Federal Reserve 2006-08) in August 31 2007:

“The big gains in housing prices we have seen here and in many other countries have raised concerns about what might happen to economic activity if those price gains are reversed. Developments in the housing market can also affect credit markets. Furthermore, problems in the subprime mortgage market have led investors to reassess credit risk and risk pricing, thereby widening spreads in general and weakening the balance sheets for some financial institutions. Fortunately, the overall financial system appears to be in good health and the US banking system is well positioned to withstand stressful market conditions.”

Clearly, our knowledge of what was happening inside the financial system and the associated risk was very limited. This is a failure of regulation and we learned the lesson the hard way.

4. No doubt that some of the research that was done by economists (those in academia) did not provide any clue about what was about to happen. As Phil Lane argues in his article, this is partly a result of specialization, not all researchers are into the business of forecasting economic downturns. But there is also no doubt that some of the research in macroeconomics has been anchored in models that do no recognize enough failures in markets or deviations from rational behavior to produce or understand some of the phenomena that led to the current crisis. Part of this is because of ideological reasons (some want to believe that markets always work), part of this is because the "beauty" of dealing with simple models (the argument made by Krugman in his article).

One thing that I find missing in all those articles is to know whether there was any difference between the current crisis and the previous ones. I am not sure there is much difference. Prior to the (mild) recession of 2001 we also witnessed very similar dynamics: many expressed concerns about the valuation of stocks (more so for tech stocks). But they called the crisis way before it happened. Once it happened, we all asked the question "How did we get it so wrong?". The difference with the current crisis is that this one is bigger, so more questions are being asked. Also, economic policy has played a much stronger role during the crisis, which has probably led to a stronger debate around economics.

It is also interesting to see that during the boom year, there was as much skepticism of economists' forecasts as today so even if some economists were getting it wrong, it is unclear how much they were driving market expectations or investment and spending decisions.

We will have to wait for the next crisis and see if things have changed or we just need to conclude that economists "will never get it right".

Friday, September 4, 2009

For the last year and a half we have seen a worsening of forecasts of growth for most countries around the world. As we discussed in an earlier post, forecasts for GDP growth for 2009 had been revised downwards every single quarter starting in 2007Q4 until 2009Q1. Since then we have seen that these forecasts are becoming more stable and in the recent update by the OECD of their economic outlook we now see forecasts for the third quarter of 2009 being revised upwards - in some cases significantly. For example, the forecast for Germany was close to zero in June and it is now being revised to more than 4% (this are annualized growth rates). Below is a picture from this report.

Thursday, September 3, 2009

There is a growing debate about the increasing burden of government debt in advanced economies. As a result of the recession and the large stimulus packages, government debt is likely to increase over the coming years to levels that we have not seen in many decades. In the case of the US, the Congressional Budget Office expects government debt to go from 40.8% in 2008 to 68% of GDP in 2019 (more details here, this figure corresponds to the debt held by the public which is lower than the overall level of debt, as some of it is held by public institutions).

Is 68% too high? The debate is open and some think that while high debt in itself is not desirable, this is a number that we have seen before (Krugman has made this argument here). Others disagree and believe that this level of debt will impose a large burden on the economy (Hamilton makes the argument here).

Many countries (including the US after the second World War) have dealt with levels of debt as high or even higher than what we are likely to see over the coming years. In the US debate, there is a reference to the case of European countries that in the 90s saw levels of debt above 100% of GDP and "survive". What was their experience? Here is the picture from two of the "worst offenders": Belgium and Italy.

In both cases, the debt to GDP ratio increased above 110% of GDP. What did we learn from that experience? The good news is that countries can "survive" with such levels of debt. In fact, we need to realize that the burden that this debt imposed on the Italian or Belgian government budget was substantial because the interest rates were much higher than the rates that governments in advanced economies face today (more so the US government). Even with those high rates, levels of debt above 100% did not lead to insolvency and what we saw over the years that followed was a gradual reduction of those levels as a result of increased fiscal discipline and GDP growth.

The first piece of bad news is that the economic performance of these two countries was not great but it is hard to argue that government debt was the main reason for such a low performance. The second piece of bad news is that while the levels have been coming down, they have done so at a very low rate. The slope going up seems to be much faster than when it goes down.

Here are two other European countries that might provide a more optimistic perspective: Ireland and Sweden.

In both cases we see a much faster decline in the debt-to-GDP ratio. In Ireland, the ratio went from 105% to 25% over two decades. In the case of Sweden, the ratio decreased from 75% to 35% in about ten years. We know that high growth played a role, much more so in Ireland than in Sweden, but the trend is also a reflection of the efforts to bring discipline to the budget. The bad news is that these figures are likely to explode in the years ahead because of the current recession, a reminder once again, that the effect of the discipline of the last year might vanish quite soon.

Here is my reading of these experiences:

1. Advanced economies can live with high levels of debt-to-GDP ratios. The levels that European countries or the US are likely to see over the coming decades are manageable.

2. How easy will it be to manage the burden of the debt depends on interest rates and growth. An environment of low interest rates (the one we have seen so far) and healthy growth (to be seen) will make the lives of governments much easier.

3. There is no need to pay back the debt within the next "x" years. What matters is to keep the level of debt-to-GDP ratio under control. [Of course, there is an issue of fairness that I am ignoring, about which generation should pay for the current expenditure]

4. Having said that, we need to plan for the next crisis, even if we are still trying the get out of the current one. The real fiscal discipline shows up during good times when government manage to save the necessary resources to pay for the extra spending and the reduced taxes that the next recession will bring. In many countries, including the US, the high projected levels of debt are a result of the consequences of the current recession but also the inability of previous administrations to bring the level of debt down when growth was high.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).